Allan H. Meltzer, a professor of political economy at Carnegie Mellon University, is the author of âA History of the Federal Reserve.â

Inflation Nation

By ALLAN H. MELTZER
Published: May 3, 2009

Pittsburgh

IN the 1970s, with inflation rising, I often described the Federal Reserve as knowing only two speeds: too fast and too slow. At the time, the Fedâs idea was to combat recession by promoting expansion, printing money and making it easier for businesses and households to borrow â and worry only later about the inflation that resulted. That strategy produced a sorry decade of slow productivity growth, rising unemployment and, yes, rising inflation. If President Obama and the Fed continue down their current path, we could see a repeat of those dreadful inflationary years.

Back then, as now, the members of the Fed were well aware of the harmful effects of inflation. In private, they vowed not to let it get out of hand and several times even started to do something about it. But when their anti-inflationary moves caused the unemployment rate to rise to 6.5 percent or 7 percent, they forgot their promises and again began expanding the money supply and reducing interest rates.

By 1979, reported rates of inflation, worsened by the oil shock, had reached double digits. Opinion polls showed that the public now considered inflation to be the main economic problem. President Jimmy Carterâs choice for chairman of the Fed, Paul Volcker, said that he would fight inflation more deliberately than his predecessors. The president agreed with him, as did the chairmen of the Congressional banking committees.

With the public acceptance of the importance of low inflation, support in the administration and in Congress, and a chairman committed to the task, the Fed finally set out to correct what it had too long neglected. Instead of working only to avoid unemployment, the Fed sought to bring inflation back under control. Instead of flooding the market and banks with money, the Fed tightened its reserves. And instead of keeping interest rates in a narrow, relatively low range, Mr. Volcker let the market dictate the interest rate, allowing the prime rate to go as high as 21.5 percent. These disinflation policies continued in earnest with the 1980 election of Ronald Reagan.

Even so, the public, having already seen three or four failed attempts to tame inflation, didnât really believe that Mr. Volcker and President Reagan would stay the course. In my reading of the evidence, a decisive change in attitudes occurred only in the spring of 1981, when the Federal Reserve raised interest rates even though the unemployment rate was approaching 8 percent. This was new. This was different. People began to expect lower inflation and, in this belief, slowed the increase in wages and prices, contributing to the decline in actual inflation.

Naturally, there were critics. But their criticisms were not strong enough to reverse policy. At the 1982 convention of the National Association of Home Builders, Paul Volcker said that if he were to let up on anti-inflation efforts prematurely, âthe pain we have suffered would have been for naught â and we would only be putting off until some later time an even more painful day of reckoning.â As always in periods of high interest rates, home builders had been especially badly hurt, but when the chairman finished his speech, they gave him a standing ovation. Though they disliked his policy, they admired his determination to do what was needed.

The pain did not end. And the anti-inflation policy continued until the unemployment rate rose above 10 percent, many savings and loan institutions faced bankruptcy, and most Latin American countries defaulted on their debt. These were the unavoidable side effects of the publicâs gradual adjustment to the new economic environment. This process continued until 1983, when the reported inflation rate fell below 4 percent.

Paul Volcker is now the head of President Obamaâs Economic Recovery Advisory Board. Mr. Volcker and the administrationâs many economic advisers are all fully aware of the inflationary dangers ahead. So is the current Fed chairman, Ben Bernanake. And yet the interest rate the Fed controls is nearly zero; and the enormous increase in bank reserves â caused by the Fedâs purchases of bonds and mortgages â will surely bring on severe inflation if allowed to remain. Still, they all reassure us that they can reduce reserves enough to prevent inflation and they are committed to doing so.

I do not doubt their knowledge or technical ability. What I doubt is the commitment of the administration and the autonomy of the Federal Reserve. Mr. Volcker was a very independent chairman. But under Mr. Bernanke, the Fed has sacrificed its independence and become the monetary arm of the Treasury: bailing out A.I.G., taking on illiquid securities from Bear Stearns and promising to provide as much as $700 billion of reserves to buy mortgages.

Independent central banks donât do what this Fed has done. They leave such fiscal action to the legislative branch. By that same token, Mr. Volckerâs Fed had to avoid financing the large (for that time) Reagan budget deficits to be able to bring down inflation. The central bank was made independent expressly so that it could refuse to finance deficits. But is there a political consensus that the much larger Obama deficits will not pressure the Fed to expand reserves to buy Treasury bonds?

It doesnât help that the administrationâs stimulus program is an obstacle to sound policy. It will create jobs at the cost of an enormous increase in the government debt that has to be financed. And it does very little to increase productivity, which is the main engine of economic growth.

Indeed, big, heavily subsidized programs are rarely good for productivity. Better health care adds to the publicâs sense of well-being, but it adds only a little to productivity. Subsidizing cleaner energy projects can produce jobs, but it doesnât add much to national productivity. Meanwhile, higher carbon tax rates increase production costs and prices but do not increase productivity. All these actions can slow productive investment and the economyâs underlying growth rate, which, in turn, increases the inflation rate.

Some of my fellow economists, including many at the Fed, say that the big monetary goal is to avoid deflation. They point to the less than 1 percent decline in the consumer price index for the year ending in March as evidence that deflation is a threat. But this statistic is misleading: unstable food and energy prices may lower the price index for a few months, but deflation (or inflation) refers to the sustained rate of change of prices, not the price level. We should look instead at a less volatile price index, the gross domestic product deflator. In this yearâs first quarter, it rose 2.9 percent â a sure sign of inflation.

Besides, no country facing enormous budget deficits, rapid growth in the money supply and the prospect of a sustained currency devaluation as we are has ever experienced deflation. These factors are harbingers of inflation.

When will it come? Surely not right away. But sooner or later, we will see the Fed, under pressure from Congress, the administration and business, try to prevent interest rates from increasing. The proponents of lower rates will point to the unemployment numbers and the slow recovery. Thatâs why the Fed must start to demonstrate the kind of courage and independence it has not recently shown.

Milton Friedman often said that âinflation was always and everywhere a monetary phenomenon.â The members of the Federal Reserve seem to dismiss this theory because they concentrate excessively on the near term and almost never discuss the medium- and long-term consequences of their actions. Thatâs a big error. They need to think past current political pressures and unemployment rates. For the next few years, they cannot neglect rising inflation.

we have 15% unemployment in some cities official in practically it's 20% unemployment

and the biggest citigroup bank is on gov't welfare.

auto workers shutting down and on GOV'T welfare.

man even wall street is on WEFLARE Wall street IS on welfare.

two industries on gov't welfare...prices don't go up if people don't have jobs or cash to pay higher prices.

you don't have inflation with people losing their jobs and getting wage cuts.

inflation occurs when everybody has cash from their jobs..JOBS

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"Inflation occurs when everybody has cash from their jobs..JOBS"

What do you think the stimulus plan is for, its to create fresh new jobs and get unemployment lower again, with trillions being spent and interest rates as low as they can go what do you think will happen when the economy turns around sometime over the next 20 years, inflation will erupt. Do you think the fed will time it just right to start raising rates again to keep inflation in check, the answer is NO, there timing is always off.

What do you think the stimulus plan is for, its to create fresh new jobs and get unemployment lower again, with trillions being spent and interest rates as low as they can go what do you think will happen when the economy turns around sometime over the next 20 years, inflation will erupt. Do you think the fed will time it just right to start raising rates again to keep inflation in check, the answer is NO, there timing is always off.

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Exactly, and what keeps inflation in check to a certain extent? Productivity. How productive are those government created jobs? Not very.

The trillions of dollars of spending/bailouts have to get paid from someone, sometime. The only variables are: who and when. Debt naturally defers the pain till later, but the total pain is higher, that is the whole point; you borrow 5 apples to eat today, but you have to pay back 10 apples over the next 10 years.

The payback will be in proportion to what has been borrowed, which is trillions of dollars. The only question is what form will the payback take: a) direct tax increases b) cuts to government programs c) indirectly through inflation. With a populist government in place, the political pressure on the central banks to inflate will be immense, as it is less well understood by the populace then tax increases and spending cuts. I see a combination of all 3. 50% of the debt will be paid back through future inflation, 25% through future higher taxes and 25% through future spending cuts.

The spending cut portion will most likely predominantly take the form of lower real social security payments, which is politically possible by some sleight of hand: there is a difference between official inflation and true inflation.

Fractional reserve credit systems depend on asymmetric asset price movement (upwards). Since our credit multiplier (most of our money supply) is responsible for for where asset prices go, and it is inextricably linked to the price of existing assets on bank balance sheets (like this nice reinforcing circular concept?), a central bank that runs within a fractional reserve system will always better serve the broad economy by keeping price levels going in the same direction as required by the banking system to keep solvency.

A leveraged monetary system that sees deflation take hold enables a lot more damage to aggregate demand, the credit multiplier, etc.

It is one way or the highway, and the Fed is targeting inflation because that is the only way that works when you have a leveraged monetary system. There IS NO OTHER WAY, except inefficient use of capital dictated by 100% reserve banking systems (which then are not vulnerable to deflation events in the same way).

Why doesn't Meltzer write articles about how the credit multiplier presents a problem that always puts the fed in this position. Since they don't directly control it (they can not easily force the multiplier to an arbitrary number, especially when business conditions are poor), they don't directly control the money supply. And thus they never really know how much money is in the system until the signs become clear they need to suck the money back in (too late).

This wrinkled political economy professor should know better... He sounds like a complainer that wants attention. I guess they get paid by the word and know that arcane discussion of such details as what makes money supply tick isn't quite appealing to the populous. But that's the core of the discussion, and gets neglected 98% of the time.

EDIT: This guy should write articles about the money multiplier instead.. Would be a better use of his talents:

Allan H. Meltzer is an American economist and professor of Political Economy at Carnegie Mellon University's Tepper School of Business in Pittsburgh, Pennsylvania[1]. He was born February 6, 1928, in Boston, Massachusetts. He is the author of dozens of academic papers and books on monetary policy and the Federal Reserve Bank, and is considered one of the world's foremost experts on the development and applications of monetary policy[2]. He is currently at work on Volume II of his History of the Federal Reserve Bank, which covers the years since the Federal Reserve accord in 1951 to the present day.